Avoiding the Next Financial Meltdown

In a previous article, we discussed the problem with banks guaranteeing fixed deposits while actually investing the money into speculative, long-term ventures, and how such an arrangement naturally leads to bank runs. There is a second problem in this scenario as well; one that is so commonplace that most people do not even stop to ask this question: Why are banks even in the business of making investments?

When you as a consumer deposit money in a bank, what service exactly are you seeking from the bank? If you’re anything like most people, you just want the bank to store your money in a safe & liquid manner, easily accessible for transactions through checks, debit cards, ATMs and such. And banks do indeed excel at this role. They do an excellent job of physically safeguarding money and greasing the wheels of commerce by acting as a convenient and trusted middleman.

So why are they stepping beyond this role and engaging in loans and other investment activities as well? To put it simply, the problem with banks is that they do too much. They provide an essential administrative service to the public: Safely keeping people’s money and enabling transactions to occur in the marketplace. The problem is, they are simultaneously also engaged in a completely different service: gambling this money on speculative investments. It would be as if the mailman not only delivered letters, but also opened the letter, read its contents, and rewrote portions of it based on what you really needed to hear.

There is no ostensible reason why the administrative services provided by the bank should be forcibly tied together with their investing services, particularly when considering the risks involved (by definition) in all investment activity. If consumers want to loan out or invest their money, 3rd party investment funds such as Bond Funds already exist for this express purpose. These are extremely stable funds, immune to bank runs by design.

Banks could have services tying in to these 3rd party funds, allowing consumers to invest their deposits into these funds the same way they currently do in Savings Accounts. And the bank for its part, could avoid all the associated loan/investment risks, and focus on the one service it does best: Safeguarding financial assets and being a middle-man greasing the wheels of commerce.

The Volcker Rule

In fact, this problem isn’t limited to commercial banks alone. Many other financial institutions, such as Investment Banks, share the same problem as well. Similar to commercial banks, Investment Banks also provide a number of vital administrative services. They help startups with the IPO process, aid established companies with issuing new securities, and help matchmake the buyers and sellers of financial instruments. They perform an essential role in the economy, hence why the collapse of Lehman Brothers and Bear Stearns sparked such widespread panic.

Unfortunately, that’s not all they do. Investment banks have also been engaging in speculative investments, with profits and losses accruing directly to the firm itself. Such forms of risk taking helped pad their profits during times of calm, but led to the financial meltdown during the last market crash. Eventually, we the taxpayers had to come to their rescue, simply to keep the wheels of commerce turning.

Similar to commercial banks, there is absolutely no reason for Investment Banks to engage in such investment activity. Mutual funds and Hedge Funds already exist for this express purpose. Individual hedge funds make bad bets and go out of business all the time. No one bats an eyelid when they do, because we don’t depend on them for any other vital services. They might be risky, but at least their risk is contained, and that makes them expendable.

With Investment Banks on the other hand, because of the wide array of other essential services that they perform, they end up being Too Big To Fail. Which really is just a fancy way of saying that they can do anything they want, and we the taxpayers will be the ones cleaning up after them. Heads they win, tails we lose.

A ray of hope: Some politicians are starting to come around and recognize this problem. The Volcker Rule was specifically created to ban Investment Banks from engaging in investment activity, precisely for these reasons. Unfortunately, the bank lobbyists have been hacking away at the bill, and exemptions have been created allowing Investment Banks to invest in Hedge Funds, Private Equity Funds, Treasuries, Municipal Bonds, and GSE Bonds such as those of Fannie Mae/Freddie Mac. Exemptions have also been added allowing Investment Banks to engage in market-making activities.

The net effect has been to dilute the Volcker Rule, and leave Investment Banks vulnerable once again to the near meltdown that we experienced in 2008.

Jack of All Trades, Master of None

Software Engineers have spent the past decades painfully learning how to build massively complex systems, that are also robust and resilient. One of their central learnings is known as the Single Responsibility Principle. To summarize crudely, it teaches us that every entity should be responsible one thing, and one thing only. Trying to pack a wide variety of completely unrelated features, into a single entity, is a recipe for chaos and disaster. We would be wise to learn from these lessons and apply them to our financial systems.

Commercial and Investment Banks provide a number of essential services, that are absolutely vital to the healthy functioning of our economy. Hence why they need to be completely decoupled from any investment activity. Investing is fundamentally a risky process, and any large scale investment is prone to sudden and catastrophic failures. Individual investment funds can and will implode from time to time, but as long as the administrative services of the financial industry are completely decoupled and left intact, the wheels of commerce can still continue running and will eventually recover again.

Only by enforcing a strict separation between administrative/transactional services, and investment activities, can we hope to avoid the financial panics that have been hitting us regularly every decade.